Variable annuities (VA's) are contracts, resembling mutual funds, offered by insurance companies. Investors purchase these contracts to save for retirement. According to NAVA, the National Association for Variable Annuities, Americans have approximately $800 billion currently invested in variable annuities.
Investors obtain many valuable benefits through the use of these products, such as:
The ability to invest in a large number (as many as sixty in some cases) of equity and fixed-income choices within one contract;
A guaranteed death benefit payable by the insurance company, typically at least equal to the amount invested, regardless of the performance of the investment choices made within the contract;
Immediate annuity purchase rates guaranteed for the life of the contract, and
The ability to receive income for life, regardless of how long the annuitant may live, by applying funds to an immediate annuity (known as “annuitizing”).
An important criterion for the success of any investment strategy is its after-tax return. There are two main categories of tax treatment for variable annuities. VA's may be categorized as either “non-qualified” (in which case they are used to supplement tax-qualified retirement savings plans such as pension plans, IRA's, and 401(k) plans) or qualified (in which case the contract is actually a component of a qualified plan such as a 401(k) plan).
Non-qualified variable annuities are tax-deferred, so long as the requirements imposed by the Internal Revenue Code are satisfied. Key among these are diversification requirements on insurer separate account assets, and that investment companies (mutual funds) made available through a VA cannot also be available to the general public, i.e. they must be insurance-only mutual funds.
If these requirements are satisfied, then investment income inside a variable annuity contract, whether arising from interest, dividends, or gains on the sale of securities, is not currently taxable to the owner of the contract until it is withdrawn or paid out as a death benefit. Tax-deferral is a mixed blessing, however, because taxes are merely deferred, not forgiven, and the (eventual) tax treatment of annuity withdrawals and death benefits is unfavorable compared with that of direct equity holdings. Amounts withdrawn from an annuity have been taxed first as income, then as return of basis, since the early 1980's. Additionally, income resulting from annuity withdrawals or death benefits is always classified as ordinary income: it loses any characterization that it would have had as capital gains or dividend income if the income had been received directly.
On the other hand, failure of a VA to meet the requirements of the Internal Revenue Code leads to a worst-of-all-possible-worlds result: Regulation 1.817-5(a) provides that the product will lose its tax deferral, but that dividends and capital gains will still be taxed as ordinary income.
The disadvantages of this ordinary income treatment, relative to directly holding equities in a brokerage account, have been exacerbated by recent tax reform. H.R. 2, The Jobs and Growth Tax Relief Reconciliation Act of 2003, which became law on May 28th 2003, reduced the top marginal income tax rate on ordinary income to 35%, while reducing the top rate on dividends and long-term capital gains to 15%. This makes long-term buy-and-hold equity investments inside a VA relatively less attractive than they were previously. However, short-term trading strategies and market-timing strategies are still attractive inside a VA, since they would tend to generate short-term gains taxable at a higher rate. As a result, these strategies continue to benefit from the tax deferral offered by a VA.
A key decision for investors is, therefore, the appropriate allocation of their retirement funds to:
a) tax-deferred investments (such as VA's), versus
b) currently-taxable investments seeking to generate dividend income and long-term capital gains (such as stocks and mutual funds),
to minimize total income tax payable over some planning period.
Additionally, passing on assets to heirs in a tax-efficient manner is often an important planning objective for investors. Stocks and mutual fund shares held directly by the investor receive a “step-up in basis” at the investor's death, so that only gains occurring thereafter will be taxable to the heirs when the equity is eventually sold. In contrast, equities held within a variable annuity do not receive a step-up in basis—any gain over the amount invested is taxed as ordinary income.
Because the guarantees offered by variable annuities are generally not available to the funds allocated to currently-taxable investments, investors trying to minimize income taxes may be compromising their death benefits or retirement income benefits. Complicating the issue further, many actively-managed mutual funds trade very frequently with the objective of maximizing pre-tax, rather than after-tax, returns, so that currently-taxable investments may not even achieve the sought-after long-term capital gains treatment.
Life insurance carriers issuing traditional variable annuities also face a number of difficulties, including the following problems:
Declining equity markets have hurt VA sales;
Declining equity markets have also led to lower fee income, making it hard for carriers to recoup the acquisition costs of the business in force;
Many guaranteed options (such as the Guaranteed Minimum Income Benefit (GMIB), and the Guaranteed Minimum Death Benefit (GMDB)) that life insurance companies sold during the equity market run-up of the late 1990's were underpriced, and in many cases insufficient reserves were set up for these benefits. Losses on this business have harmed the bottom lines of a number of carriers; and
As regulators have become aware of these problems they have made multiple revisions to reserve and capital requirements for VA carriers, with the continuing uncertainty in this area making it difficult to develop new products or forecast financial results for existing ones. In addition to these existing problems, recently-enacted H.R. 2 makes tax-deferred products relatively less attractive, with some insurance industry analysts projecting a resulting 20% drop in annuity sales.
Life insurance distributors also face a number of problems, including the following:
Low sales resulting from weak equity performance; Carriers are retrenching on VA benefits, i.e. raising prices on previously-underpriced benefits;
There has been little product innovation recently, leaving distributors with little or no “sizzle” to sell; and
It will likely become harder to sell the ordinary income treatment of annuity withdrawals when investments held directly are taxed more favorably.
Accordingly, there is a long-felt need for a variable annuity product that complements existing VA products, by permitting the investor to achieve dividend and long-term capital gains tax treatment on their retirement funds, without giving up the other benefits and guarantees of a variable annuity. There is correspondingly a long-felt need for a computer-based system to be used to price such a variable annuity product.